Inflation, Monetary Policy & Pandemics
Sunday Reads

Inflation, Monetary Policy & Pandemics

By August 1, 2021 No Comments

Visualizing History


From theĀ Archives

Book page image

The Money Problem (1874)

Sunday Reads

Happy Sunday, everyone! Hope you’ve all had a great week. This week was a major one for the upcoming Investor Amnesia history course, as I secured aĀ massiveĀ speaker for the already brilliant lineup. It is killing me not to share his name, but suffice it to say that many of you will have read this Scotsman’s book at some point… šŸ™‚ And for those that cannot wait for the second course, check out the first course onĀ Bubbles, Manias & Fraud.Ā Fun update for that course, we’ve now reached 600 enrolled students!

But for now… grab a cup of coffee, get comfortable, and let’s dive in to some historical context on the major themes and narratives moving markets.

Democratizing Markets & The Robinhood IPO

While this will not be the main focus of today’s Sunday Reads, I have to spendĀ some time on Robinhood’s IPO after the company has dominated financial news outlines and narratives for so much of the pandemic. Although speculation is very much alive and well, it does seem to be petering out a bit, as I discussed two weeks ago. That said, the disappointing public market debut for Robinhood felt like an apt metaphor for the declining levels of speculation that the platform enjoyed earlier in the pandemic, when there was well and truly a day trading army.

Robinhood has been a focal point for financial commentators, investors and pundits for much of the pandemic as the platform proved to be most popular among the new generation of traders and investors. Then there was the whole fiasco around GameStop and halting purchase orders on certain meme stocks, which wound up landing Robinhood’s founder in front of a congressional committee. Much of the conversation has focused on “protecting the retail investor” and “democratizing markets”. Exactly who is this individual retail investor, and why do we all seemingly condescend to and patronize this investor? Retail investors tend to be referred to in this diminishing way, but has this always been the case?

One of the link’s in today’s Sunday Reads looks at the evolution of how we perceive retail investors in America since the late 19th century. The author argues that there are four distinct eras with different narratives around the retail investor:

“In the first, pre-1933 era (ā€œThe Birth of Dispersed Ownershipā€), stockholding expanded rapidly, as did the moral case for that expansion. In the second, 1933ā€“1970 (ā€œCultivating the New Investorā€), ownership expanded further, with a particular emphasis on a paternalistic vision of cultivating new middle-class investors while protecting them from the perils of the market. From 1970ā€“2000 (ā€œLeveling the Playing Fieldā€), that paternalism faded in favor of a more muscular view of retail investors, who should develop self-reliance and participate actively in stock-picking, a theme reinforced by retail investorsā€™ self-conceptions. The final era, 2000 to the present (ā€œFinancial Turmoil Brings the Investor Citizen into Questionā€), is one of unresolved tensions.

A series of crises suggested that ā€œMain Streetā€ investors were now so enmeshed in the markets that they faced undue peril. At the same time as that seemed to suggest more regulation was needed, growing attention to inequality simultaneously sparked calls for more access to markets for those Main Street investors.”

More on that later. One interesting snippet from this article is worth highlighting now:

“attitudes towards the wisdom of individual stock-picking have fluctuated over the century… in the 1950s, some SEC commissioners worried that mutual funds would deprive investors of both the impetus and savvy to engage in individual stock-picking.

Later, especially after the rise of modern portfolio theory and the invention of passive index funds, the pendulum swung in the opposite direction, with a growing emphasis on the benefits to the average individual investor of diversification and passive investment.“

Remarkable, right? While it is hard to imagine today with all of the preaching on index funds, there was a time when SEC commissioners were concerned about mutual funds depriving investors of their stock-picking abilities! How times have changed. Anyways, make sure to read that paper to learn more about how the retail investor has been characterized and treated since the late 1800s. The paper also includes a section specifically putting the recent meme stock episodes into historical context.

Inflation & Monetary Policy

The topic we will spend most of today’s post on is Inflation & Monetary Policy. Today’s posts will cover how the government’s monetary response to pandemics in both 17the century Venice and the 1918 Spanish Flu interplayed with inflation and economic recovery. As many investors are concerned over how the Fed’s pandemic policies will impact markets post-COVID, now is a good time to study what happened in the past. Here is one great excerpt on the Spanish Flu in particular:

“One indicator of the impact on leisure spending is perhaps Major League Baseball attendance. Overall attendance fell by over 50% from 4,762,705 in 1917 to 2,830,613 in 1918 before more than doubling to 6,532,439 in 1919 after the pandemic came to an end.

The possibility that the baseball data are indicative of a more far reaching pent-up demand could help explain the fact that, after the pandemic came to an end, rising bank loans financed a ā€œspeculative orgy of 1919ā€.

One major fear is that the Fed is mishandling recent signs of inflation, and is wrong about these signs being “transitory” due to COVID-19. The major question for investors is “what assets work best during periods of inflation”? Well, as I teased yesterday on Twitter, one of the papers in today’s post has someĀ brilliant tables and insights for answering this very question. For example:

More specifically, how did different equity sectors perform during these bouts of inflation?

The paper containsĀ many more tables like this, so without wasting any more time, let’s dive into today’s Sunday Reads!

The Best Strategies for Inflationary Times

Why This is Relevant:

This paper is worth reading if only for the brilliant tables on how various assets / sectors perform during different inflationary regimes dating back to World War Two. Since inflation seems to be the primary source of fear and anxiety for investors today, this paper offers a useful look back at what investments and strategies worked best in past periods of inflation.

Summary:

“Over the past three decades, a sustained surge in inflation has been absent in developed markets. As a result, investors face the challenge of having limited experience and no recent data to guide the repositioning of their portfolios in the face of heighted inflation risk. We provide some insight by analyzing both passive and active strategies across a variety of asset classes for the U.S., U.K., and Japan over the past 95 years.

Unexpected inflation is bad news for traditional assets, such as bonds and equities, with local inflation having the greatest effect. Commodities have positive returns during inflation surges but there is considerable variation within the commodity complex. Among the dynamic strategies, we find that trend-following provides the most reliable protection during important inflation shocks. Active equity factor strategies also provide some degree of hedging ability. We also provide analysis of alternative asset classes such as fine art and discuss the economic rationale for including cryptocurrencies as part of a strategy to protect against inflation.”

Visualizing History:

Notable Quote:

“Our results suggest that trend-based strategies focusing on equity, bonds, FX, and commodities have strong hit rates during the eight inflation episodes and provide an impressive level of protection. We consider a range of equity portfolios and find that popular factors like value provide some benefit during our definition of inflationary times. While the average benefit is small, for example 3% real returns for a quality strategy to -1% for the value strategy, these factor portfolios perform far better than passive investments in stocks or bonds. The equity factors also have the extra advantage of high capacity.”

Pandemic Recession, Helicopter Money and Central Banking: Venice, 1630

Why This is Relevant:

One of the primary concerns for investors is what the lasting impact of the Fed’s pandemic policies will be once COVID-19 eventually subsides and normalcy resumes. This fascinating paper takes readers back to Venice during the plague of 1630-1631 for insights on what lasting effects the government’s “helicopter money” approach to monetary policy had.

Summary:

“This paper analyses the monetary policy that the Most Serene Republic of Venice implemented in the years of calamities using a modern equivalent of helicopter money, precisely an extraordinary money issuing, coupled with capital losses for the issuer. We consider the 1629 famine and the 1630-1631 plague as a negative macroeconomic shock that the incumbent government addressed using fiscal monetization. Consolidating the balance sheets of the Mint and of the Giro Bank, and having heterogenous citizens ā€“ inequality matters – we show that the Republic implemented what was, in effect, helicopter money driven by political economy reasons, in order to avoid popular riots.”

Visualizing History:

Notable Quote:

“the monetary policy implemented during the pandemic recession years produced an over-expansion of scriptural money coupled with losses in issuer capital ā€“ the central bank had to be bailed out by the government. Moreover, although the government avoided any debasement policy, convertibility on demand of scriptural money into coin had to be suspended. Price instability and currency devaluation were the final macroeconomic outcomes. The price dynamics needs to been analyzed in depth, given that in general pandemics can lead to rich inflation dynamics with strong inflationary as well as deflationary forces.”

Which Investors to Protect? Evolving Conceptions of the American Shareholder

Caption:Ā ā€œWall Street Persians & The Washington Egyptians

At the battle of Pelusium, between Egypt and Persia, the Persians armed themselves with cats, the sacred animals of Egypt. The disconcerted Egyptians dared not shoot their arrows, for fear of hitting holy cats.ā€

Explanation:

ā€œIllustration shows the battle of Pelusium with the Persians identified as having ā€˜Vested Interestsā€™ (looking like Chauncey M. Depew), belonging to a ā€˜Wall Street Syndicateā€™ (looking like John D. Rockefeller), or a ā€˜Railroad Trustā€™, throwing cats labeled ā€˜Small Stock Holder, Small Investor, Widow, Little Stock Holder, [and] Orphanā€™ at the bewildered Egyptians who are outside a building labeled ā€˜Administrationā€™ and flying a banner labeled ā€˜Federal Prosecutionā€™.ā€

Why This is Relevant:

Within the financial services industry, “democratization” is currently the buzzword du jour. Let’s just say that the term is also being used “liberally”, to put it mildly. As with most buzzwords that plague the industry, the “democratization” narrative is now being wielded by a variety of institutions looking to capitalize on this trend. Every FinTech startup is now democratizing something, and has a mission of helping/protecting the “helpless” retail investor.

However, why does the industry often refer to smaller retail investors in this condescending and patronizing tone? Has the average retail investor always been viewed in this way? Well, this paper looks at the history of how average American shareholders have been perceived and treated since the late 1800s.

“stylized images of the investor are driven by changes in politics, technology, and culture. In turn, the images influence regulatorsā€™ views both about how to protect investors, and about how investors should behave in a normative sense.

For instance, attitudes towards the wisdom of individual stock-picking have fluctuated over the century… in the 1950s, some SEC commissioners worried that mutual funds would deprive investors of both the impetus and savvy to engage in individual stock-picking. Later, especially after the rise of modern portfolio theory and the invention of passive index funds, the pendulum swung in the opposite direction, with a growing emphasis on the benefits to the average individual investor of diversification and passive investment.

Today, perhaps suggesting that the pendulum has not come to rest, the SECā€™s Office of Investor Education and Advocacy awkwardly embraces stock-picking alongside passive index fund investing in its introductory investing materials.”

Better yet, the last section of the paper specifically touches upon the GameStop saga within this broader historical context.

Summary:

“A system of investor protection rests on a theory of which investors need protection. This chapter surveys the composition and perception of individual investors in American capital markets from 1900 to the present. The retail investor base has expanded remarkably during that time. Beyond the statistics, distinct ā€œimagesā€ of the shareholderā€”that is, perceptions of the prototypical American investorā€”have dominated at different moments of U.S. securities law history. Although no one image will ever capture the full complexity of capital markets, I attempt to identify prevailing images in specific eras of securities regulation history, by examining comments by policymakers and industry participants. These images influence policy priorities and design.”

Visualizing History:

U.S. Equity Ownership (Percentage)

Notable Quote:

“For much of early American business historyā€”through the mid-19th centuryā€”the landscape had been dominated by smaller, owner-managed businesses, often in the form of partnerships or sole proprietorships. Those businesses gave way to larger-scale industrial enterprises in the late 19th century, ownership of enterprise was both concentrated and very much the province of the wealthy. The best-known and largest firms either bore the names of their owners or were deeply linked in the public imagination to themā€”Carnegie, Rockefeller, Mellon, Ford.

For the most part, American participation in the stock market was rare, and seen as highly risky. Risk, to be sure, had a long and complicated relationship with the American ethos. But in 1899, by some accounts, less than 1% of Americans owned either stocks or bonds.

That changed rapidly in the next decade… in 1932, a seismic restructuring in capital formation had already occurred. The highly concentrated ownership of the Gilded Age was giving way to a system of dispersed shareholding and centralized management, one that more closely resembles our contemporary markets. That transformation was ā€œrapidly increasing, and appeared to be an inevitable development,ā€ already quite pervasive in the largest businesses… those ā€œmultitudinous investorsā€ were not simply the rich but also those of ā€œsmall or moderate means.ā€

The US Money Explosion of 2020, Monetarism and Inflation: Plagued by History?

Why This is Relevant:

While the earlier paper looked at 17th century Venice for comparisons on pandemic monetary policy, this paper looks at a more recent example: The Spanish Flu of 1918. The authors study how Fed policy, pent-up demand, and inflation all interplayed, and how they impacted the economy. Sound familiar?

Summary:

“Although the Federal Reserveā€™s quantitative easing of early 2020 was comparable in scale to 2008-2009, the implications for the growth of money in circulation and future inflationary pressures appear quite different. Absent the unprecedented surge in bank excess reserve ratios seen in 2008 and after, massive monetary base increases imply the possibility of a much larger, and potentially worrisome, increase in the money in circulation.

Rising inflation expectations are implied by such phenomena as the surging demand for Treasury Inflation Protected Securities and record highs for gold prices during the summer of 2020. These trends lend some support to market participants evincing concern that the surging money growth is, in fact, a precursor to future inflation.

Historical perspective on the 2020 situation is provided by data from the time of the 1918-1919 Spanish flu and available documentation of inflation following medieval and Roman-era pandemics. Indications of extra upward pressure on prices arising from pent-up spending after the epidemic has passed include the surge in bank loans in the aftermath of the 1918-1919 Spanish Flu pandemic.”

Visualizing History:

Notable Quote:

“One indicator of the impact on leisure spending is perhaps Major League Baseball attendance. Overall attendance fell by over 50% from 4,762,705 in 1917 to 2,830,613 in 1918 before more than doubling to 6,532,439 in 1919 after the pandemic came to an end.

The possibility that the baseball data are indicative of a more far reaching pent-up demand could help explain the fact that, after the pandemic came to an end, rising bank loans financed a ā€œspeculative orgy of 1919ā€. Even as the Federal Reserve maintained an unchanged discount rate, this policy had far from neutral effects given that the strong demand for loans at this time meant that it was ā€œprofitable for commercial banks to expand the stock of money at the then existing discount rateā€.

This was accompanied by high levels of member-bank borrowing that subsequently deterred the Federal Reserve from reducing discount rates even as deflation set in during 1920. As shown inĀ Figure 3 (above), money supply and prices rose together from 1915 through the end of 1919, prior to entering the sharp but relatively short-lived deflation of 1920-1921.”

 

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